Authorities are developing new tools to boost financial stability. But they need a clearer idea of what ‘stability’ means.

By Richard Barwell

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One of the many lessons of the Great Recession was that fundamentally flawed bank regulations were a major contributor to the crisis. In an attempt to correct that mistake, authorities around the globe are now trying to compensate with a raft of new reforms, including some that haven’t been properly thought through.Among the more familiar regulatory tools, standards on capital have been tightened up while new standards on liquidity have been introduced. Healthy skepticism has replaced a tick-box supervisory culture. Authorities are even getting serious about tackling the problem of too-big-to-fail institutions.Now comes the introduction of a macroprudential regime, designed to complement these microreforms by counteracting the destabilizing swings in the financial cycle. This macro regime will try to insulate financial institutions from the latent risks that can build up in a boom so that they are better placed to provide core services during a bust. Should the commercial-property market start to overheat, for example, a macroprudential policy maker might require that banks start funding more of their commercial-property loans with loss-absorbing capital. This ambitious macroprudential agenda has already been put into practice in the U.K. by the Financial Policy Committee.The FPC is supposed to make the U.K. financial system more resilient and thereby protect the supply of core financial services. But beyond that, there is a complete lack of detail. There are no targets, for example, for the level of resilience or the provision of core services that the FPC is supposed to deliver. Is the FPC supposed to eliminate financial crises altogether, even at the cost of draconian limits on the banks’ capacity to provide services or offer innovative financial products? Or is the objective to keep the frequency of crises, and the serious disruption to the supply of core financial services that follows, down to some tolerably low level, whether that should be at most once a century or some other limit? Without that explicit target, the FPC cannot make coherent decisions about the adequacy of regulatory requirements on capital or liquidity.Likewise, there is no working definition of what constitutes an appropriate provision of core financial services. At what point does an increase in rationing at the micro level, with low-income households unable to get access to credit, become a macro problem that the FPC should deal with?When it comes to raising capital requirements to increase resilience, some economists argue that there is no such thing as too much. There is no downside, according to this view, to forcing banks into funding a greater share of their business with capital. Under certain assumptions, raising regulatory capital requirements has no impact on, say, the supply of credit.However, practical policy makers don’t buy into that model and instead see a trade-off between the resilience of the banking system and the terms on which it provides its services. This includes the numbers of households and companies that are effectively rationed out of credit markets, and the cost of credit for those who can still get access. Politicians therefore need to give macroprudential policy makers much clearer guidance about how to manage this trade-off.The current set-up also rules out genuine accountability. How can there be an assessment of whether the FPC has failed or not if its objectives haven’t been clearly outlined? The recent intervention in the mortgage market illustrates this accountability deficit. The FPC introduced a cap on the proportion of new mortgages that banks could originate at loan-to-income multiples in excess of 4.5. The committee acted not because those loans threatened financial stability but because they were judged to pose a threat to the nebulous concept of economic stability. Whatever the merits of the intervention, the committee’s justification for action involved an elastic interpretation of its remit. And yet there was little scrutiny of the decision.The macroprudential agenda is worth persevering, but policy makers need to improve their understanding of how the financial system behaves. Politicians need to provide greater clarity on the objectives of the regime. The sooner the regime is put on a proper footing, the better.Mr. Barwell is a senior economist at BNP Paribas Investment Partners.

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